Understanding the Network Effect: How It Increases Product Value

What Is the Network Effect?

The network effect is a phenomenon that increases the value of a product or service as more people use it and relate their experiences to others. This engagement contributes to the increased value and reach of a product. Users can become product advocates, which helps spread awareness and drive sales growth for businesses. Social media and e-commerce platforms have helped enlarge the network effect. For instance, Etsy and eBay grew in popularity by accessing online networks and attracting consumers to their products.

Historical Origins of the Network Effect

The network effect idea began in the early 20th century with the telephone's arrival.. Theodore Vail, the first post-patent president of Bell Telephone, used the network effect to argue why Bell Telephone should have a monopoly on telephone networks.

Robert Metcalfe, who created Ethernet, popularized the idea with Metcalfe's law, saying a network's value is proportional to the square of its users.

Understanding Direct vs. Indirect Network Effects

There are two main types of network effects: direct and indirect. Direct effects occur when a product's value increases as the number of users increases. Telephones were the first example of an item with direct network effects.

Sometimes one product can spur new technology or innovation. When the use of a product leads to new items, indirect effects occur. The original item becomes more valuable along with the supporting items. Video gaming systems and subsequent games are an example of this.

How Participation Fuels the Network Effect

As more people join, the network effect can enhance the user experience. It can also encourage new participants as they look to benefit from the network. The internet is an example of the network effect. Initially, there were few users on the internet with its only traffic from the military and scientists. As more users gained access, they produced content, information, and services. The development and improvement of websites attracted more users to connect and conduct business.

Network effects can be found throughout social media. Platforms become more useful as users post more content. Networking platforms like Facebook, YouTube, and Instagram have grown rapidly due to the network effect.

Companies eager to advertise join these platforms to capitalize on the trend. The increase in advertisers leads to more revenue for social media websites. As a result, the sites evolve and offer more services to the consumer.

Comparing Network Effect and Network Externality

While similar, network effects and network externalities are distinct. Network externality is an economics term that refers to how the buying patterns of consumers are influenced by others purchasing a product.

For example, a crowded restaurant parking lot may tell consumers it sells good food. Trends in fashion also influence buying patterns. Clothes routinely go in and out of style based primarily on copycat buying and selling patterns.

Positive externalities can create a network effect. If a consumer's friends are on Facebook, they might join hoping to connect, which is a positive externality. If they join and post quality content, that may lead to many people enjoying the experience, boosting engagement, and creating a network effect.

Leveraging the Network Effect for Business Growth

The network effects that exist on the internet often benefit a variety of services-for-hire apps and websites. As more professionals, such as dog walkers, tutors, or electricians, list their services online, more customers rely on those online directories. E-commerce sites, such as Etsy and eBay, grew in popularity as more sellers joined those marketplaces and sold their products to consumers who embraced online shopping.

Companies such as Uber and Lyft evolved and grew the support of participants who signed up and expanded the companies' reach across cities and states. Leveraging the network effect can help grow a business. Once the effect occurs, users effectively act as salesmen, spreading news of the product.

Companies may offer new items cheaply or free to trigger a network effect. As demand for the product grows, prices increase and people become willing to pay more. The more people who use the product, the more value the product has.

Pros and Cons of the Network Effect

The chief hurdle for any company that seeks to benefit from the network effect is gaining traction or attracting enough users so that the effect can take hold. The number of users required for a significant network effect is called the critical mass. After critical mass is attained, the good or service attracts additional new users because of the utility or benefits to the consumer, helping the company become self-sustaining.

However, if too many people use a good or service, congestion may occur. Providers of goods and services that use a network effect must ensure that capacity can be increased sufficiently to accommodate all users. After reaching critical mass, companies might become less efficient or innovative due to a stable customer base.

The Bottom Line

As a product grows in popularity, users effectively act as salesmen, spreading the word about it and its company. And as even more people use that product, its value and utility increase for everyone involved. Network effects are significant in various sectors, including telecommunications, social media, e-commerce, and service-for-hire platforms. Reaching critical mass is crucial for a network effect to take hold and propel business growth. But businesses must manage user capacity effectively to avoid congestion and inefficiencies. Meta, Apple, and Airbnb are just three of the many companies that have successfully leveraged network effects for their growth.